Air Canada upgraded To ‘BB-’ From ‘B+’ on stronger sustained credit measures

• Favorable pricing and traffic growth this year, particularly on international routes, has contributed to lower debt levels and stronger sustained credit measures for Air Canada, in our view.
• We now estimate the company's adjusted funds from operations (FFO) to debt in the high 30% area at the end of the year, well exceeding our previous forecast.
  
• As a result, S&P Global Ratings raised its issuer credit rating on Air Canada by one notch to 'BB-' from 'B+'.
  
• At the same time, we raised our issue-level rating on the company's secured debt by two notches to 'BB+' from 'BB-', stemming from the upgrade on Air Canada, along with our estimate for stronger recovery prospects in a default scenario following prepayment of certain aircraft loans this year.
  
• We also raised our issue-level ratings on many of Air Canada's enhanced equipment trust certificates (EETCs) primarily reflecting our upgrade on the company.
  
• The positive outlook reflects our expectation for FFO to debt to be near or above 30% over the next couple of years, which we consider high for the rating.
  

S&P Global Ratings today took the rating actions listed above. The 2023 financial results are trending well above our previous forecast primarily owing to strong demand on international routes. Air Canada reported second- and third-quarter results that were significantly better than we had expected, and the company is well on track to generate adjusted EBITDA of C$3.9 billion this year (about 55% higher than we had assumed earlier this year). These results reflect very strong demand for international travel and contributed to strong traffic growth, load factors, and pricing. Capital expenditure (capex) is also trending a bit lower than we had assumed for 2023 due in part to a delay in the delivery of a Boeing 787-9 aircraft to next year. Air Canada's robust earnings and free operating cash flow (FOCF) generation in recent quarters also facilitated the prepayment of more than C$1 billion of aircraft loans, which contributed to the strengthening of the company's credit measures, without compromising the strong liquidity position. We now expect adjusted FFO to debt will be 35%-40% this year and remain at or above 30% through 2025, which we consider strong for the rating and this could lead to another upgrade within the next 12 months.

Our 2024 guidance remains unchanged, but we expect capex spending beyond 2023 will be much higher owing to the company's plan to expand its widebody fleet. Our earnings assumptions beyond 2023 are not materially different from our previous review because we believe the strong passenger revenue per available seat mile (PRASM) growth this year (14.2% based on our estimate) will partially reverse and decline by about 7.0% in 2024 and 2.0% in 2025. This incorporates our view that interest rate increases over the past couple of years have yet to have their full effect on discretionary spending in Canada. Therefore, weaker demand and rising competition could pressure yields. Furthermore, while we assume cost per available seat mile (CASM) will decline modestly in 2024 as capacity continues to increase, we believe it will remain 15%-20% above pre-pandemic levels owing to inflationary pressures, including labor costs that are expected to increase further next year as Air Canada renegotiates the contract with its pilots that expired earlier this year.

We expect total revenue in 2024 and 2025 will be 18%-19% higher than 2019 as capacity nears pre-pandemic levels and PRASM remains comparatively higher. Still, we believe structurally higher operating costs will persist and contribute to adjusted EBITDA that is 5%-10% lower than it was in 2019, with EBITDA margins in the mid-teen percentage area versus the high-teens percentage area previously. Furthermore, despite capex trending lower than we previously thought in 2023, we expect it will step up considerably in 2025 and 2026. In September 2023, Air Canada announced an order to purchase 18 B787-10s with deliveries scheduled between fourth-quarter 2025 and first-quarter 2027, with the option to purchase 12 more. After entering the order contract with Boeing, Air Canada canceled its purchase order for two Boeing 777 freighters that were scheduled for 2024 delivery, which we believe was due in part to slowing near-term demand for air cargo shipments and belly capacity that comes with the B787-10s. Based on Air Canada's recent earnings call comments, the company could take out some of its existing B777-300 ER and/or A330-300 fleet as the new B787-10s are delivered. In our opinion, this widebody expansion strategy provides Air Canada with the opportunity to expand its premium international traffic and could lead to stronger returns than if it were to add capacity in what is shaping up to be an increasingly crowded domestic market. However, this strategy is not without its risks. For instance, the capex required is significant and will contribute to FOCF deficits in 2025 and 2026 based on our estimates. This could leave Air Canada with less financial flexibility if operating conditions deteriorate. We assume annual capex will average about C$3.5 billion from 2024 to 2026 (compared with about C$2.0 billion previously) and be funded at least partially with new debt. That said, it's worth noting that there could be delays in the timing of these deliveries, either due to manufacturing delays at Boeing or if weaker air travel demand leads Air Canada to renegotiate its delivery schedule.

Ongoing negotiations with pilots could result in higher operating costs than we currently assume. Bargaining talks with Air Canada pilots began earlier this year after the company's 10-year agreement reached in 2014 came to an end. The previous contract included annual average pay increases of 2%, which has not kept pace with inflation and Air Canada pilots have joined with the Air Line Pilots Association (ALPA), the world's largest pilot union in May. We assume a new contract is likely to be announced in early 2024 and will include pay increases that are similar to or slightly higher than those that WestJet pilots (also part of ALPA) were awarded this summer (a 24% increase in hourly wages by 2026). That said, the ongoing negotiations add downside risk to our forecast earnings, because it could lead to booking disruptions or higher labor costs than we currently incorporate.

Domestic competition is heating up and could weigh on longer-term profitability. Competition in the Canadian market is intensifying with the expansion of Porter Airlines and ultra-low-cost carriers that include Flair Airlines, Lynx Air (formerly Enerjet), and Canada Jetlines. We believe these airlines will focus on routes targeting continental North America, including flying from airports that are competitive with Air Canada. Of these airlines, we think Porter poses the largest challenge to Air Canada. The airline has plans to significantly expand, with firm orders for 50 Embraer E195-E2s placed last year, of which 25 are expected to be delivered this year. Porter also began flying out of Toronto's Pearson International Airport in February 2023, one of Air Canada's key hubs. In our view, Air Canada is less exposed than its main domestic rival (WestJet Airlines Ltd.) to competition from ultra-low-cost carriers given its premium service focus, international traffic diversity, and varied/differentiated services. In addition, we believe that much of the capacity increase would likely be absorbed by higher air travel penetration and organic growth. Although we can't ignore the prospect of some price risk on specific routes (at least in the short term) and growth on the affected routes, we believe Air Canada can leverage its network to effectively manage this risk. Arguably, in our opinion, there also remains significant uncertainty about the financial success of all the new entrants given weak precedence of new airline successes in Canada, particularly in the current environment of high fuel prices, interest rates, inflation, and pilot shortages.

Downside risks to earnings on multiple fronts over the next few quarters limit rating upside for now. We are taking a patient approach to further rating upside for Air Canada, mainly due to a confluence of risks and uncertainties that could lead to meaningfully lower earnings, particularly over the next 12 months. These include our expectation for a weaker Canadian economy next year, increased industry capacity, the possibility of higher jet fuel prices if current geopolitical conflicts escalate, and the extent to which pilot wages increase. The airline industry has been highly cyclical historically and sensitive to changing economic conditions. Slower-than-expected demand, particularly if jet fuel prices remain elevated, could have a material effect its earnings.

The positive outlook reflects our view that Air Canada will generate credit measures that we view as strong for the issuer credit rating, including adjusted FFO to debt at or above 30% despite slowing air travel demand next year.

We could revise the outlook to stable if, over the next 12 months, we expect Air Canada will generate FFO to debt well below 30% over the next couple of years. This might occur from higher-than-expected costs and the effects of a weaker Canadian economy or competitive pressures that reduce Air Canada's traffic, revenues, and margins.

We could raise our rating within the next 12 months if we see sustained improvement in traffic and we continue to expect Air Canada will generate and maintain FFO to debt approaching 30% or higher. In this scenario, we would expect the company to meet our current estimates for EBITDA and FOCF generation. Greater visibility regarding the potential impact of increased capacity, cost inflation, and weaker macroeconomic conditions on Air Canada's passenger traffic and margins is likely required for us to better assess the sustainability of our forecast credit measures.

Environmental factors are a moderately negative consideration in our credit rating analysis of Air Canada. Similar to other airlines, the company faces long-term risk from tighter greenhouse gas emissions regulation. The company is mitigating this risk by retiring older aircraft and investing in more efficient new aircraft. Its average fleet age is about 12 years.